Big stock profit could result in brutal tax hit

When the Dow finally wiped out its late-winter losses to set a new record, it was good news - no doubt about it.

But the more you make in the stock market, the more you pay in taxes. And new data suggests that mutual fund investors now enjoying the stock market's fine returns could well be hit with whopping capital gains distributions this year - perhaps the largest ever.

That would bring some big tax bills next spring.

These bills have been mounting for a couple of years. The Investment Company Institute said recently that mutual funds paid out more than $259 billion in capital gains distributions in 2006 compared with $129 billion the year before.

It was the largest figure since the record $326 billion at the peak of the stock-market bubble in 2000.

The distributions, usually paid late in the fall, represent profits on stocks or other holdings that fund managers sold out of their portfolios during the year. By law, any net gains must be paid - distributed - to fund shareholders. And they are taxable unless the fund is in a tax-favored account such as a 401(k) or IRA - even if they automatically are reinvested in the same fund.

Start with a look at the records you used for the tax return you filed this spring. If you received big payments from one or more funds - detailed on 1099 forms from brokerages and fund companies - think about moving your money to funds that tend to have smaller distributions.

That means selling funds you now own, but you don't have to do it all at once. That might trigger a big tax bill, too, if you sell shares for more than you'd paid for them. If you bought shares at various prices over time, you can sell just those bought at the highest prices, such as ones purchased over the past couple of years. That will give you the smallest gain on which to pay taxes.

Years ago (before I knew better), I invested in several funds that later made very large annual distributions. I've whittled these holdings in the past few years by turning to them first whenever I needed to sell shares to rebalance my portfolio or pull cash from my accounts.

Your broker or fund company can tell you how to designate specific shares to sell.

The fund-data company Morningstar has a terrific tool for finding "tax efficient" funds: the Similar Funds tool at www.morningstar.com. Type the ticker symbol of the fund you want to replace, and the tool will produce a list of funds with similar holdings.

Click on any of those funds and then hit the Tax Analysis button. You want funds that have tax-adjusted returns as close as possible to their pre-tax returns. That shows they did not give up a lot of gains to taxes.

If you want a different type of fund, search with one of Morningstar's screeners. With that, you can find "tax-managed" funds designed to minimize distributions. With these, managers use strategies such as selling losing stocks to offset gains that were realized on winners.

Index funds and exchange-traded funds, which are funds that trade like stocks, are tax-efficient because they simply hold stocks in a market gauge, such as the Standard & Poor's 500, and make few sales. In contrast, actively managed funds tend to have bigger distributions because managers do lots of selling in pursuit of hot stocks.

If you decide to hang on to funds that make big distributions, keep good records. When distributions are reinvested, the amount is added to your "cost basis," which is the total paid for the shares you own. That reduces the profit realized when you eventually sell the shares, and it therefore cuts the tax bill you'll face when you finally bail out of the fund.